Why the Most Successful VC Firms Keep Winning

Investing in software companies is an inherently uncertain activity. It’s labeled as high risk, but “highly uncertain” is a better term. Yes, you’re taking a risk with money, but the real problem is the widely variant potential outcomes. If you invest in a restaurant, you are taking a risk, but you will either end up with a profitable restaurant or lose your money. If you invest in a software company, you can go bankrupt, have a small but profitable company, sell for five times the money in, or end up with a world-spanning multibillion-dollar behemoth that turns everyone it touches into a millionaire.

That dramatic range is why you can get a bank loan to start a restaurant but not a software company. It’s exactly why people invest in software, but also why it’s so difficult to do well.

There’s no proven method for managing this kind of uncertainty. The most successful investors frequently get it massively wrong, and a playbook that worked perfectly in one circumstance will fall flat in many others. Yet even when they frequently make monumentally bad investments, the best investors keep delivering the best outcomes. If no one knows what separates the best from the rest, why do some firms or individuals keep winning?

Many would say the best investors keep winning because they can tell a great company from a bad one, but a little inspection shows that even the best don’t actually believe this. Fantastically successful investor Paul Graham once said that he can be tricked by anyone who looks like Mark Zuckerberg. He’s since claimed that was a joke, but Graham built his empire by making more bets than anyone else, which is a strategy explicitly designed around the fact that he doesn’t actually know why some things succeed and others don’t. Disgraced investor Dave McClure began 500 Startups with the similar goal of just making lots of bets, rather than making any attempt at making “good” bets. You can see the industry trends point to admitting there is no clear system, even if individuals still cling to deserving their greatness.

Even those who invest in venture capital firms have given up on knowing who’s best. Given a pot of money allocated to venture capital, limited partners will distribute it across many firms, knowing they have to play many hands to get a winner. After all, venture capital, on average, returns about the same as the overall market. The winners win big, and the rest balance that out, so LPs need to put money in enough places to be confident they’ll end up with enough of the winners.

If no one knows the difference between the best and the worst, why do the winners usually keep winning?

Access.

Venture capital is all about access: founders having access to capital, and investors having access to the best deals. If you’re a founder today and have a choice between taking money from a top-tier firm that keeps delivering hits or another firm you don’t know and that hasn’t done well, which do you take? Of course you take the best firm with the biggest network and most well-known brand name.

Similarly, if you’re an investor who has helped take lots of companies public, how does your deal flow compare to those who are just starting out and who don’t have a reputation for building big companies? Of course the best companies come to you.

In other words, there’s an implicit matching algorithm at work in VC, where companies that are obviously doing well are able to work with what look like the best firms, and as a result, they reinforce each other’s success. The best firms look better because the best companies seek them out, and the best companies do better because they’re getting the chance to work with the best brands. (For all that I am skeptical of repeatable investment skill, I am a deep believer in the value of brands.)

Venture capital is a tense balance between by the asymmetric pressures placed on investors and founders by the need for access; every entrepreneur stresses out about how they’ll get access to capital, and every investor’s business model is built around managing deal flow. Entrepreneurs who have already had a great outcome magically have no trouble raising huge amounts of money, and yesterday’s great investors have no trouble convincing today’s great companies to work with them.

This focus on access also helps to explain some of the churn the system experiences. If no one knows what makes a great company, how can the best investors always get access? They can’t. Plenty of great companies fail to get first-tier support early on. If they do raise money, then those who backed them end up looking like tomorrow’s geniuses, and the cycle starts over with them closer to the top.

This access-based sorting also helps to explain how the VC industry is so discriminatory. Less than 5 percent of investment goes to women-led companies, and just having a woman founder ruins a team’s chance of getting funding; the numbers are worse for firms led by African-Americans. If we believed investors actually knew what they were doing, then we could only conclude that they were correct to exclude women and minorities from investments, that these founders just couldn’t build great companies.

Of course, the data clearly says otherwise: Founding teams with women on them significantly outperform male-only teams. Because investors don’t know how to pick a good company from a bad one, they are relying on access and reputation, and because they’ve never let women or minorities in before, they can’t now. Their “pattern matching” doesn’t hit here.

This matching algorithm that runs our industry is reliant on privilege and luck. Venture firms and founders are almost exclusively white men from expensive schools (with a huge proportion from just Stanford and Harvard), and if you were lucky enough to be an early employee at Facebook or Google (which have historically used the same sourcing requirements), then that’s a big leg up, too.

To be clear, I think some investors are much better than others, and entrepreneurs haven’t built huge, successful businesses out of sheer coincidence. It’s not that there’s no skill involved or that the people who get so rich instead deserve nothing. It’s that skill is an overappreciated (and often small) part of what determined their success.

You will rarely find communities admitting that privilege and luck are major contributors to outcomes. Human nature has a deep aversion to accepting this. Instead, we do what we have done forever: We develop myths.

Humans deeply believe that people get what they deserve and deserve what they get, despite evidence to the contrary. So many of our cultural biases are stories created to justify realities we would like to perpetuate. For millennia we’ve been told that royalty was special, and that’s why they were in charge, when it was patently obvious that their ancestors were just the best and most ruthless at organizing enough troops to control a chunk of land. Genghis Khan was history’s greatest murderer, which enabled him to spawn kings and kingdoms that lasted for seven centuries, but you can bet his descendants didn’t use his skills at genocide as justification for their lofty positions.

Similarly, myths have grown around venture capital that exist to explain the winners and losers. Somewhat like royalty, these myths help convince us that VC is more than privileged people using their positions to make lots of money. They must be winning because they deserve to win. Equivalently, people lose because they didn’t deserve to win. You could waste your life reading about how this founder got rich because they were smart and worked hard or how that investor succeeded because of their investment strategy, but you couldn’t consume a morning with the stories of equally smart founders who worked just as hard but went broke or investors who applied that same strategy but somehow didn’t make it to the Midas list.

Thankfully, we’ve seen some really interesting experiments focused on eliminating access as a criteria for investing. Social Capital recently launched a programmatic algorithm, and Village Capital uses peer decision-making between entrepreneurs. Backstage Capital was founded explicitly to invest in those who can’t get capital from the system as it exists today.

With these and related efforts, I’m optimistic that we can begin to peel back the myths about what makes a great investor, entrepreneur, or company and instead begin building a more open market around investment and company creation. Only then can we hope to see venture capital include, enrich, and benefit all parts of the economy.